Can ETCs replicate the carry trade?

By Felix Salmon

November 16, 2009

Denise Law ran an article about a set of new currency ETCs which are going to be listed on the London stock exchange -- think ETFs, but for foreign exchange. She quoted Nik Bienkowski, the chief operating officer at ETF Securities, which has created these instruments:
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Now I’m confused. Back on November 6, the FT’s Denise Law ran an article about a set of new currency ETCs which are going to be listed on the London stock exchange — think ETFs, but for foreign exchange. She quoted Nik Bienkowski, the chief operating officer at ETF Securities, which has created these instruments:

“The benefit of a currency ETC is that it provides exposure to local interest rates. It’s safer than putting money in a foreign bank account,” Mr Bienkowski said.

Is this an interesting new way to play the carry trade? As a good blogger should, the FT’s Izabella Kaminska revisited the subject on Friday, and found all manner of reasons why small investors should stay away from this product. Most startlingly, she writes of the maximum upside from investing in these things, that they have

all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then).

So which is it? Does the ETC provide exposure to local interest rates, or does it pay not interest or dividend at all? The official website for these things says that they “reflect movements in exchange rates between two currencies, plus exposure to local interest rates”, which seems pretty clear. But Index Universe says something rather different:

Each ETC will track the total return version of one of the Morgan Stanley Foreign Exchange (MSFX) indices. The total return index for any given currency pair has two components: a constant (long or short) position in the relevant MSFX currency, achieved by daily rebalancing via a “spot-next” transaction, and an interest component which tracks the one-month US dollar Treasury bill rate.

That’s certainly the impression I get from the official MSFX documentation:

For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily at the One-Month T-Bill Rate… Hence, the daily return on the related MSFX Total Return Index will be computed as the sum of the MSFX Currency return and the One-Month T-Bill return.

There certainly doesn’t seem to be any mention of local interest rates there. And given how much one-month Treasury bills are likely to yield for the foreseeable future, you’re not going to get much in the way of interest on that front, either.

So I’m confused about why and how ETF Securities is claiming that ETCs provide exposure to local interest rates. Is there something I’m missing here?

Update: I understand them now. And yes, they do provide exposure to local interest rates. Or they’re designed to, anyway.